Capital Structure Valuation and Capital Budgeting with Debt

1. Capital StructureValuation and Capital Budgeting with Debt Finance - Pedro Barroso

2. Valuation • So far, we have valued investment projects (or firms) as if they were purely equity financed • Under the Modigliani and Miller assumptions, this approach is valid • But, we have shown that deviations from these assumptions causes value to depend on financing choices • Interest payments are tax deductible • Financial distress is costly • Optimal tradeoff between tax benefits and distress costs may also be affected by harder-to-quantify costs and benefits of debt versus equity (information sensitivity, incentive effects, etc) • How do we adjust our valuation techniques to account for the effects of financial leverage?

3. WACC: Intuition • WACC approach accounts for value of interest tax shields by adjusting discount rate downwards relative to discount rate for an unlevered firm (rU) • Intuitively, WACC measures average return that the firm must pay to its investors on an after-tax basis • To be profitable, an investment project should generate an expected return at least equal to this average Finance - Pedro Barroso

4. Using WACC: Step 1 • Estimate free cash flows from the investment (or firm) • Ignore interest payments to debt holders • Ignore tax deductions from debt financing Free Cash Flow = EBIT – Corporate tax (if no debt existed: EBIT (1 – t)) + Depreciation – Change in net working capital – CAPEX Finance - Pedro Barroso

5. Using WACC: Step 2 • Value project (or firm) by discounting stream of free cash flows using WACC as discount rate • rE: cost of levered equity (expected return on equity) • rD: cost of debt (expected return on debt) • t:effective marginal corporate tax rate (= top marginal tax rate if the firm is consistently profitable) • E: market value of equity (= market capitalization) • D: market value of debt (= book value of debt is a common assumption)

6. WACC Calculation

7. Cost of Debt • rD: cost of debt (expected return on debt) • Yield-to-maturity of corporate bonds • CAPM: • Debt beta is lower than equity beta (“hard to estimate”) • Notice that debt beta is zero if cost of debt equals risk-free rate • Common to assume debt beta equals zero

8. Market risk premium: Cost of Equity Capital: CAPM • To estimate a firm’s cost of equity capital, we need to know three things: • Risk-free rate: rf • Firm equity beta (levered): • Note that: Finance - Pedro Barroso

9. Determinants of Equity Beta • Business Risk • Cyclicality of Revenues • Operating Leverage • Financial Risk • Financial Leverage Finance - Pedro Barroso

10. Cyclicality of Revenues • Highly cyclical stocks have higher betas • Empirical evidence suggests that retailers and automotive firms fluctuate with the business cycle • Transportation firms and utilities are less dependent upon the business cycle • Note that cyclicality is not the same as variability -stocks with high standard deviations need not have high betas • Movie studios have revenues that are variable, depending upon whether they produce “hits” or “flops,” but their revenues may not be especially dependent upon the business cycle Finance - Pedro Barroso

11. D EBIT Sales DOL = × EBIT D Sales Operating Leverage • Degree of operating leverage measures how sensitive a firm (or project) is to its fixed costs • Operating leverage increases as fixed costs rise and variable costs fall • Operating leverage magnifies the effect of cyclicality on beta • Degree of operating leverage is given by: Finance - Pedro Barroso

12. Financial Leverage and Beta • Operating leverage refers to the sensitivity to the firm’s fixed costs of production • Financial leverage is the sensitivity to a firm’s fixed costs of financing • Relationship between the betas of the firm’s equity (levered) and assets (unlevered): • Financial leverage always increases the levered beta relative to the unlevered beta Finance - Pedro Barroso

13. Unlevered and Levered Beta • Unlevered beta is a weighted average of the levered beta and debt beta: Finance - Pedro Barroso

14. WACC: Example Company is considering expanding production (scale-enhancing project): • Current stock price is $30, there are 100 million shares outstanding and equity beta is 1 • Debt has market value of $1.5 billion and is currently at its long-term target leverage ratio • Expansion costs $50 million and would generate expected free cash flows of $10 million per year starting next year and continuing in perpetuity • Current risk free rate is 6% and the expected market premium is 8% Finance - Pedro Barroso

15. WACC: Example • Yield to maturity of company bonds is 10% • Company expects to be consistently profitable and, therefore, taxed at a marginal rate of 30% • What is the NPV of the expansion project? Finance - Pedro Barroso

16. WACC: Example Step 1: Find WACC • Cost of debt (rD): we can use the YTM of 10% • Cost of equity (rE): we can use CAPM to find cost of equity capital • Thus,

17. WACC: Example Step 2: Value project • We can now use WACC to discount free cash flows to find the project’s NPV • Because the firm’s target leverage is 0.33, the project’s debt capacity is 0.33 x 86 = 28. • That is, firm requires 28 in additional debt to maintain its target leverage ratio if it undertakes the project. Maintaining target leverage of 0.33 does not mean that the firm must finance 0.33 of the required 50 investment with debt!

18. Changing Operational Risk and/or Target Leverage • Suppose the firm is making a project with a different operational risk • We should use operational risk of project (not of company) • Use unlevered beta of comparable firms of industry average beta adjusted by target debt-to-equity • Suppose project changes firm’s target debt-to-equity • We should use target debt-to-equity of project (not of company) • Use levered beta calculated using the target debt-to-equity of project Finance - Pedro Barroso

19. Changing Operational Risk and/or Target Leverage • Step 1: Find U(business risk) • We know L, D and (D/E) from industry (comparable firms) • We can use the levering formula to find βU: • Step 2: Estimate D (and rD) of the project using CAPM

20. Changing Operational Risk and/or Target Leverage • Step 3: Find L using project (D/E) and D and levering formula: • Step 4: Compute the project rE(using CAPM or MM proposition 2) • Step 5: Use the project rE, rD, and (D/E) to find the project WACC

21. Example: WACC Returning to our previous example, suppose that instead of expanding operations, the company is investing in a new line of business: • Industry equity beta is 1.5, cost of debt 9% and debt-to-equity is 0.25 • Project will be financed at the company current capital structure and cost of debt Finance - Pedro Barroso

22. Example: WACC • We first need to calculate the industry unlevered beta: • estimate industry D: 0.09 = 0.06 + Dx 0.08 D= 0.375 • estimate industry unlevered beta: • We next calculate the project levered beta: • estimate project D: 0.1 = 0.06 + D x 0.08 D= 0.5 • estimate project levered beta:

23. Example: WACC • We calculate the project cost of equity using CAPM: • Finally, we calculate the project WACC: • We can now use WACC to discount free cash flows to find the project’s NPV

24. Example: WACC • In alternative we can use MM proposition 2 to estimate the project cost of equity: • estimate industry cost of equity: • estimate industry cost of unlevered equity: • Estimate project cost of equity:

25. Adjusted Present Value (APV) APV = NPV + NPVF • Value of project can be thought of as value of the project to an unlevered firm (NPV) plus the present value of financing side effects (NPVF) • There are four side effects of financing: • Interest tax shield • Costs of issuing new securities (flotation costs) • Costs of financial distress • Subsidies to debt financing Finance - Pedro Barroso

26. APV: Example Consider a project with the following incremental after-tax cash flows for an all-equity firm: –$1,000 $125 $250 $375 $500 0 1 2 3 4 The unlevered cost of equity is rU = 9%: Project would be rejected by an all-equity firm: NPV < 0 Finance - Pedro Barroso

27. APV: Example • Suppose firm finances the project with $600 of debt at rD = 8% • Tax rate is 30%, so they have an interest tax shield of 0.3×600×0.08 = 14.4 each year • After-tax interest of 600×0.08× (1 – 0.3) = 33.6 • Present value of interest tax shield: • APV = –31.1 + 47.69 = 16.6 > 0 • So, company should accept the project with debt Finance - Pedro Barroso

28. APV: Example • Suppose now firm finances the project with $600 of debt at below market rate of 2% (government subsidy) • After-tax interest of 600×0.02× (1 – 0.3) = 8.4 • NPVF captures both the interest tax shield and the non-market rate effect; notice that we discount at 8% (market rate) • APV = –31.1 + 131.2 = 100.1 > 0 • So, company should accept the project with debt Finance - Pedro Barroso

29. APV: Example • Suppose firm finances the project with $600 of debt at rD = 8% • Firm has to pay flotation costs of 1% on gross proceeds, so gross proceeds should be such that net proceeds is 600 Gross proceeds x (1 – 0.01) = 600 Gross proceeds = 600 / 0.99 = 606.1 • Tax rate is 30%, so they have an interest tax shield of 606.1×0.08×0.3= 14.55 each year • After-tax interest of 606.1×0.08× (1 – 0.3) = 33.94 • Flotation cost is 606.1 x 0.01 = 6.06 but it generates a tax shield of 0.3×6.06 / 4 = 0.45 each year Finance - Pedro Barroso

30. APV: Example • Present value of interest tax shield: • Present value of flotation costs: • APV = –31.1 + 48.19 – 4.57 = 12.52 > 0 • So, company should accept the project with debt Finance - Pedro Barroso

31. Flow to Equity Approach (FTE) • Discount the cash flow from the project to the equity holders of the levered firm at the cost of levered equity capital rE • There are three steps in the FTE Approach: • Step 1: Calculate the levered cash flows (LCFs) • Step 2: Calculate rE • Step 3: Value the levered cash flows at rE • LCF = FCF – Interest expenses after taxes – Debt repayments Finance - Pedro Barroso

32. Step 1: Levered Cash Flows • Suppose firm finances the project with $600 of debt at 8% • Thus, equity holders only have to provide $400 of the initial $1,000 investment: CF0 = –400 • Each period, equity holders must pay interest expense; after-tax cost of the interest is: 600×0.08×(1 – 0.3) = 33.6 • Levered cash flows are: • Year 1: 125 – 33.6 = 91.4 • Year 2: 250 – 33.6 = 216.4 • Year 3: 375 – 33.6 = 341.4 • Year 4: 500 – 33.6 – 600 = -133.6 Finance - Pedro Barroso

33. Step 2: Calculate rE We need to calculate the debt to equity ratio (D/E) Finance - Pedro Barroso

34. Step 3: Valuation • Discount the cash flows to equity holders at rE = 10% Finance - Pedro Barroso

35. Summary: APV, FTE and WACC APV WACC FTE Initial Investment All All Equity Portion Cash Flows UCF UCF LCF Discount Rates rU WACC rE PV of financing effects Yes No No Finance - Pedro Barroso

36. Summary: APV, FTE and WACC • Use APV when the level of debt is known over time • The APV method is frequently used for special situations like interest subsidies, flotation costs, LBOs, and leases • Use WACC and FTE when the debt-equity ratio is constant over time • WACC is by far the most common • FTE is a reasonable choice for a highly levered firm Finance - Pedro Barroso